Experts warn of systemic conflicts

Federal government reforms and a crackdown by the corporate regulator have failed to stamp out inherent conflicts of interest within ratings agencies, experts warn.

The warning came after Federal Court judge Jayne Jagot found investment bank ABN Amro had “sandbagged" and “bulldozed" Standard & Poor’s into giving it favourable AAA ratings. Her comments came during a landmark decision that found S&P’s ratings of complex financial products had misled the market.

But a visiting fellow at the University of New South Wales, Vic Edwards, who has been engaged by the Australian Securities and Investments Commission to conduct audits of the industry, warned that despite licensing and annual compliance reports, there were systemic conflicts.

“The institutions will go to a ratings agency and say, ‘we have a new instrument, can you rate it for us?’ So how can you have an organisation rate your product and pay them for it and say that they are at arm’s length? That is something that they haven’t overcome in the pure sense," Mr Edwards said.

He said he was concerned about the level of training and expertise of staff within the industry, which comprises three international players S&P, Fitch and Moody’s and three local agencies.

“One of my criticisms of the students coming out of University is that they are also often not given an understanding of what is happening in real life. Because nothing went wrong for about 20 years, there was a form of complacency which just crept into the industry," Mr Edwards said.

A lawyer for one of the parties involved in the case, Norton Rose partner Stephen Klotz said the decision had broken new ground because investors had been able to recover against S&P, despite not having a direct relationship.

“The decision shows ratings agencies need to take more care in the opinions they express, maintain their independence, not bow to the pressure from their clients and form independent and objective views formed on a reasonable basis.

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“They can’t hide behind the investment bank which engages them because ultimately they have exposure to investors," Mr Klotz said.

In delivering an emphatic victory to the 12 councils who had sued ABN Amro and S&P for misleading conduct, Justice Court judge Jayne Jagot was scathing of the failure of the ratings agency to maintain its independence. The judge took issue with the ­volatility assigned to the complex financial products that formed part of the ratings calculation which she concluded was “hopelessly deficient".

“ABN Amro’s willingness to deploy that rating when it knew all S&P did and more, remains at the heart of all of the derelictions of duty," Justice Jagot said.

Mr Edwards said that: “S&P were given a model by ABN Amro which had many inbuilt features which were incorrect. The S&P people just didn’t do their job well enough and the ABN people knew what was biasing things but they lent on S&P fairly heavily so that they would still come out AAA rated."

He said ABN Amro’s rivals were bringing out AAA-rated complex financial products and “they wanted something which would present as the equivalent".

Melbourne University’s Ian Ramsay, who led a government review of the independence of auditors a decade ago, said the decision would cause headaches for rating agencies.

“What we see here is the ongoing issue with a lack of independence of the key gatekeepers in the financial system and the consequences of that were significant for many thousands of ratepayers," Professor Ramsay said. “The judge’s rulings could potentially be used by investors in future cases involving credit rating agencies," he said.

However, Parliamentary Secretary to the Treasurer Bernie Ripoll said the government had introduced significant reforms and there were no plans for more changes at this stage.

“I will await a report from ASIC but it is a different regulatory environment now than pre-GFC and we have a robust legal system to deal with these issues," he said.

Piper Alderman partner Amanda Banton, who ran the proceedings, agreed the decision highlighted the inherent conflict of the ‘issuer-pays’ ratings process. “There appears to have been an incentive for S&P to issue high credit ratings rather than accurate ones," Ms Banton said.